On Aligning Stakeholder Incentives in Blockchain Systems
Highlights of Dr. Cathy Barrera’s MIT Lecture
One of the brightest minds in the tokenomics space, Dr. Cathy Barerra of the Prysm Group, delivered a remarkable lecture at the 2019 MIT Cryptoeconomic Summit on aligning stakeholder incentives when building blockchain systems. This article highlights our key takeaways from the presentation. The full lecture can be found here — a must-watch for anyone building in this space.
Blockchains are markets that are encoded so that individuals can interact and exchange value.
Incentives for performance are used when it is important that participants engage in certain value generating activities but these actions can not be directly observed.
Both areas of expertise (economics and engineering) are integral to developing sustainable blockchain systems due to the inherently human and inherently codified nature of blockchains.
Blockchain Design takes Both Engineering Mindsets as well as Economic Thinking
Economists think about blockchain systems differently than engineers…
- Economists think about how people interact with each-other through blockchains; What choices are they making? What resources are they contributing? How are they impacting the platform?
- Economists look at how we can get to an equilibrium result in behavior; Behavior can not be fully controlled, but behavior can be pushed towards equilibrium through incentives.
Engineers think about blockchain systems differently than economists…
- Engineers think about the machinery and software aspects of blockchains: Things that can be engineered a certain way, and things that can be controlled.
- Engineers look at how we can develop sustainable code and optimize the efficiency of systems.
Both areas of expertise are integral to developing sustainable blockchain systems due to the inherently human and inherently codified nature of blockchains.
The Limits of Smart Contracts & Formal Incentives
It is very difficult to measure the behavior that we intend to encourage. It is very difficult to build an incentive that encourages the exact ends we desire. We make incentive-building decisions based on prior experience, the breadth of research available on this topic, as well as a certain amount of heuristics.
There are two key limitations to keep aware of when building smart contracts and incentive systems:
- problems with pay-for-performance, and
- contract incompleteness.
Incentive Mechanisms & Pay-for-Performance Problems
Pay-for-performance is a system that uses compensation to encourage value-adding activity. While it is ultimately necessary aspect of most incentive systems, there are a few common problems that plague its implementors.
Common Pay-for-Performance Problems
- Free Riding: Multiple individuals contribute to an outcome, but individuals contributions cannot be individually observed or are still able to gain value from the output of the collective without contributing themselves. As a result, individual contributors may shirk responsibilities.
- Example: Many DAOs (decentralized autonomous organizations) experience problems with free-riders when inventive mechanisms allow non-participatory members to benefit from the platform without contributing to its governance themselves.
- Multitasking: The success of the community or project depends on participants engaging in multiple activities, which are not equally mesurable. The participants may overemphasize the most measurable activities.
- Example: Three core goals of Bitcoin are decentralization, adoption, and security. It is difficult, if not impossible to measure if individual miners are achieving distributed control. What the Bitcoin code can measure is the amount of hash power that goes into supporting the network via a tournament-style incentive system. This incentive system achieves Bitcoin’s adoption and security goals, but not necessarily its goal of decentralization.
- Gaming: The actions participants are paid for do not perfectly capture activities that are value generating. Not compensating positive contributions can lead to decreased motivation for good actors. Inadvertently compensating value-neutral or value-negative actions can lead to individuals focusing on actions that increase their own payoff without creating value for the collective.
- Example: On the EOS MainNet, block producers (network hosts) are voted for by token holders. The creators of this voting mechanism intended that block producers who are best able to sustain the network receive more votes. Over time, some block producers began paying token holders to vote for them. The ability of a block producer to pay for votes is not necessarily indicative of their ability to sustain the network, but is nonetheless highly appealing to voters. In this scenario, existing incentives are not properly creating the desired end result.
The incentive mechanisms that are best suited to individual blockchain ecosystems can vary depending on the goals of the network. It is important to define the goals of an ecosystem prior to determining the incentive mechanisms best suited to meet those goals. Even when core goals are well articulated, it can be difficult to create mechanisms that lead to the desired result.
The Impacts of Incomplete Contracts
- We are unable to determine every possible outcome in which the contract we are writing must have effect.
- Outcomes we care about are not always measurable.
- Enforcement may not always be practical.
As we build and work within blockchain systems, we should always anticipate that there will be unforeseen consequences. We should always anticipate that there will be gaming behavior in the systems we build. To make our systems resilient to unforeseen scenarios, we must create change mechanisms that help us determine a path forward and implement any protocol updates that are necessary.
We need to adapt to gaming behavior over time rather than trying to anticipate every possible avenue in which gaming behavior might occur.
Building Effective Incentive Systems
Because of their multi-stakeholder nature, all blockchain systems need to incentivise the entities that participate in their economy to act in ways that are preferred and predictable.
Performance incentives are used when it is important that participants engage in certain value generating activities, but these actions can not be directly observed.
There are three types of mechanisms that can be used, individually or in combination to incentivize actions:
- Formal Contracts: “I pay you for a proxy of value-generating activities (e.g. sales, commissions).” These contracts are often encoded.
- Relational Contracts: “If you engage in value-generating activities, I will give you more business in the future.” These contracts are often social contracts.
- Reputational Contracts: “I support you because a trusted summary of your value-generating history is widely available.” These contracts are often both encoded as well as social.
It is important that teams building blockchain systems take the time to create incentive mechanisms that encourage good actors to add value and discourage bad actors from detracting value. That being said, the devil is in the details. Builders can never anticipate all possible opportunities for gaming behavior; thus, it is important to build systems with enough flexibility to deal with unforeseen circumstances. This can be done through building strong change-management mechanisms into your governance. Through combining incentive mechanisms, an awareness of contract incompleteness, and intelligent governance design, all communities can build more resilient and scalable blockchain networks.
[This summary co-authored by Thomas Cox and Kirsten Pomales Langenbrunner]